Italians do it better (the MBA)

Sunday, December 17, 2006

A comment on "Doing Business 2007" by world bank

When I read the “Doing Business Report” I was trying to put myself in the shoes of an entrepreneur or manager in a multinational company facing the question “now that I know all these things, should I invest in Country XX?”. For me it was like taking a decision of picking a restaurant given the knowledge of ingredients the cook is going to use to prepare dishes.

As a first general overview, I would say that this paper is organized from a country perspective rather than a business one. For each topic under exam the authors give examples and guidelines out of experiences of countries that are good reformers and others that are not. This approach can be useful for countries that want to improve on one or more specific topic (taxation, investments..) but is less effective to the eyes of entrepreneurs and companies that want to do business with or in a given country. But then, reading the detail with which topics are treated, it doesn’t seem that they are covered in deep enough to be a useful guideline for governments. The paper is focused on the indicators and a lot of words are devoted to explain how they were built and the methodology used to give scores. Which is fine, but the result is a long list of tables filled with numbers with few room left for a thorough discussion. It has to be argued who is the real target of this numbers and tables. The private sector? Governments? Or just a random reader interested in learning, at a very high leve,l which countries are reforming and how are they doing it? I will discuss what is good and bad of the paper and why I think the paper is not very useful neither for reformers nor for companies and entrepreneurs.

The first step to analyze the usefulness of the report is to understand what are the things companies look at when it comes to do business and what are the things that countries can do to make it happen. Even if the two things share the same background, there is a misalignment in terms of timing and dimension of the variables involved. Companies have a look from a macro perspective and give more weight to the profitability of today than the potential drawback in the remote future, in a perfect Net Present Value way of thinking. Many times managers have to take decision in tight time constraints and they don’t care if countries have put in place reforms that are sticky to bring tangible results in the short term. Countries, on the other hand, work on small variables that sometimes are seen as unpopular among business people or are just a small piece of change in the whole economic infrastructure. Companies and governments work on the same ground, but the outcome of actions taken by one party are not always what the other party is looking for and at the right moment. In this sense, if the Doing Business report shows that a country has decreased trade costs and time, it is still not a reason why a company should start a business there in the next few months. To trade you need partners, ports, facilities, roads and shippers that reach the country. These things take time to develop. On the other hand it can make sense to start a business with a country with high trading costs if you have a great partner to deal with, accessible ports and good infrastructure backing your business. So it might be better for a company to trade with France than Georgia even if the latter has a better ranking in terms of openness to trade. In addition, the goal of the reforms mentioned in the report have a long-term horizon, compared to decision made by companies which have a shorter time perspective. Many reforms don’t have an immediate outcome in a country’s economy and take some years to show the first results. Companies, on the contrary, act in a highly paced environment and most of the time they need to take decision very fast to generate a competitive advantage by being the “first mover”. Many investors like Ray Viault recognize the “first mover advantage” as one of the keys to be in developing countries. Again, this does not mean that a country should not reform, but that is not straight forward that new reforms introduced in a country make it immediately attractive to companies. Enabling laws that protect investors or getting an easier access to credit doesn’t build infrastructures and consumer demand from one day to the other. It takes time to trigger this chain of improvements and to establish double-sided market.

Furthermore, countries have limited resources to implement changes. It’s clear that with unlimited resources you can try to improve on every aspect mentioned by the report. But reality is different, and it’s tough to make changes happen. Having to chose which reforms to implement a country face the risk of choosing a mix that is not very effective. The topics are all complementary and mutually supportive. When multiple reforms are applied the outcome is not clear and straightforward. It’s unclear if it’s better to have a favourable taxation system but a below-average access to credit or the other way round. Every country has its own mix of good and bad things and ever business can benefit from them in different ways. As it is difficult for a country that performs well to understand which reforms were the main cause, it’s even more difficult to establish a real causation between improvement on a variable and development of the private sector and growth. If it is difficult for a government to put reforms in practice, it’s even more is even more difficult for the private sector to understand and exploit them.

The methodology used by the team that built the report is itself focused on specific assumptions that limit the scope of analysis on specific industries and businesses. Pick for example the topic of “investors’ protection”. The score on this topic is given on a specific situation in which a company is involved in a big asset purchase transaction which the authors claim is part of the normal business activities. I agree that this is a typical case in which frauds by executives are done but I am not sure if such analysis would grab many other ways of stealing assets and profits put in practice by smart directors. Accounting rules for example are many times tricky and easy to exploit. When Hermitage Capital was investing in Russia, one of the problem was the way financial statements were kept. Transparency of information by itself doesn’t prevent managers to use complicated accounting rules to steal profits from the company. These things happen in developed countries, just think about Parmalat in Italy or WorldCom in the US; in developing countries are enormously amplified. In the case of Gazprom the steal of assets was done on a daily basis, something which cannot be monitored so easily by investors not so active as Bill Browder. In addition, the report talks about auditors and give a grade based on their presence before the transaction takes place. This, again, is not a bullet proof guarantee for the investors since most of the times this external subjects are more corrupted than the company directors.

The presence of regulatory laws and agencies like the SEC is not a guarantee either. As a metaphor, it is still considered unsafe to walk around in Caracas even if homicide is punished by law in Venezuela. Even in the US, if something goes wrong with an investment, you can complain to the SEC. You can complain to state regulatory agencies. You can complain to industry organizations (for instance the NASD, an organization of securities dealers.) Thousands of people with legitimate complaints contact those regulators every year. And very few get any money back! Why? The SEC is charged with enforcing laws, not with recovering damages for individuals. The people who work for the SEC are regulators. They can check to see if laws were broken and that correct practices were followed. They can refer cases to prosecutors. But they don't recover money for investors.

Despite the critics I did against the effectiveness from the point of view of the investors, the report is more useful for reformers. From their point of view, if societies get their institutions “right” and also adopt the “right” policies, they will create an “enabling environment” for development that will transform positive economic stimuli into long-lived, virtuous circles of development. In the 2006 report trade barriers has been introduced. As noted by Jeffery Sachs, a crucial factor that allows a country to grow is technology. Technology is imported in a country through trade, either directly by local companies or indirectly through the economic engine generated by foreign investments. The growth of booming economies like China and India has been characterized by huge decrease in trade barriers, even if would be naïve to assert that all of this improvement in growth should be attributed to the greater openness. They have been engaged in wide-ranging economic reforms covering trade and other areas. But still, easiness of trade is one of the strongest growth enabler on which many economists agree. However, the five indices measured by the World Bank are not enough to tell how well positioned is a country around the topic of trade. Cross-country and, as the World Bank itself says, “behind the border” policies are also critical to a country’s investment climate. These include regulations and institutions overseeing local and foreign investment, capital markets, customs, taxation, labour, private ownership, legal recourse, and so on. The ability to trade is limited when a country is landlocked in a poor region. Ports and economic zones, like Bangalore, are the way by which India and China started their amazing path of growth, boosted, it is true, by huge foreign investments and donations from countries and foundations. But how many countries can have all this? In many countries key export sectors remain dominated by state participation (despite large scale privatization programs) and face issues in terms of governance, pricing, financing, A country can lower its import tariffs, decrease the time needed to perform the custom checks but if it doesn’t have a physical point of access to trade partners it will difficulty access the global markets anyway. In poor economies the fist trading partners are most likely other countries with similar product needs. The success of trade improvements of a country may be limited by the work done by its neighbours. Pick Georgia. The report doesn’t say anything about the tight link that exports of this country with Russia. According to The Economist Intelligence Unit, the structure of exports shifted somewhat in the first half of 2006 compared with the corresponding period of 2005 due to Russian bans on some products like wines, scrap metal and mineral water. And this is not a minor issue for Georgia. Two-thirds of domestic production of wine was exported to Russia. Scrap metal is another of Georgia's main export items. Moreover, the structure of Georgian exports is still tilted towards low value-added goods, and this is unlikely to change in the short term, as the industrial sector still needs to undergo radical restructuring. This leads to a future of exports still linked with neighbours countries’ economies.

Georgia is known to be a good follower of World Bank’s suggestions. The country has been improving considerably year after year. On average, the country has risen 40 position in rankings from year 2006 to year 2007. The GNI per capita has growth 30 percent in the last year and comparing the report of 2004 to 2007 it is notable how the same index has more than doubled, showing a strong correlation with improvements on almost all indicators (at least the ones that were present since 2004). I heard critics about the fact that for many countries to follow blindly the World Bank suggestions is the only way to get funds from the IMF. In this case it is curious to observe how Georgia performs relatively bad on newly introduced indices like “taxes” and “protection of investors”. A sign, maybe, that the country is reforming only where and when it is monitored.

The role of institutions plays a fundamental role when it comes to implement reforms following the guidelines of the report. A poor country which lack of formal and informal institutions can fall in the trap of following the index just from a numerical point of view and worsen an already sick situation. The effect of reducing firing costs in a country where unions don’t exist and workers lack of basic rights can be a step back in evolution instead of a leap ahead. Going over Georgia once more, without any doubt it has improved a lot in recent years. Georgia's notable improvement seems related to what was reported in the World Bank's Doing Business 2006 report, which trumpeted Georgia's recent introduction of major reforms to its labour laws, removing restrictions on working hours and dismissal procedures, and thereby lowering firing costs to some of the lowest levels in the world. However, Manana Kochladze, regional coordinator for the Caucasus for the Central and Eastern European Bank watch network, reports that "due to its absurdity, the introduction of the new labour code in Georgia caused protests by the entire population including businessmen. Even from a neo-liberal point of view, the new code does not bring a lot of gains to employers and it creates instability for employees." Indeed looking at the indices about the rigidity to fire employees you can notice how Georgia has a score of 0 in a region with an average of 37 and compared to the OECD which has an average of 27. We can say that the world bank gives a direction to pursue when implementing reforms, and this directions goes from 100 to 0. But the numbers don’t tell the whole story, which demonstrates that maybe the optimal score is somewhere before the 0. On the other hand, a reduction in firing costs in countries like Italy or Spain, where ironically we can say that workers are not employed but “adopted” and unions are anachronistically too powerful, would be for sure a gain in competitiveness and growth of the economy. In the specific case of Italy for example, the main reason why Alitalia, the flagship airline, is going bankruptcy is the inability of the government to fight against union and renegotiate the pilots’ contract and relocate them from the “old” national hub of Rome to the new one in Milan. Every year Alitalia has operating losses mainly because it has to pay transfer costs to pilots and crew from Rome to Milan. And there is now way to renegotiate the contracts. In this sense, the effectiveness of reforms in countries where institutions are consolidated will be more effective. Indeed every reform taken by the government needs an underlying social infrastructure characterized by transparency of information and balanced bargaining power among the parties affected.

What could have been useful are the suggestion on “how to reform” given at the end of each topic. The overall flow of discussion is well done considering the fact that it’s not a mere “do this and do that” list but covers side topics and externalities like corruption and give examples of recent reforms. However, the discussion stays on a very high level, showing that the purpose of this section is not to educate governments on how to implement reforms and improve on some indices. The cut with which arguments are treated in this section suggest instead that the target audience is a reader not very skilled about what concerns economic policies and government practices. Moreover, the report, compared for example with the one done by The Economist Intelligence Unit (EIU), lacks a thorough analysis of the political environment (which places for example corruption as a main topic and not a secondary one), the policies towards private enterprise and competition and the quality of infrastructures.

Going back to my culinary example, these topics are like ingredients for cooking a good dish. Countries are the cooks, companies are the hungry but refined customers. It’s not by telling the customers which ingredients are you putting in the dish and their quality that you ensure that the meal will be good for them. They will just taste the dish ignoring the ingredients that are into it. They will come out with their judgement or they will just observe and listen to the comments of other customers. Moreover, customers have different tastes. What is good for someone might not fit the taste of someone else. However, remains the fact that a cook needs to use only the best ingredients and a good recipe if she wants to come out with a great dish. You cannot make a good omelette with rotten eggs.

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Blogger Ashwyn said...

dude.. that must've taken forever for you to write! I'll give it a read when I'm through with Accounting and Marketing.. :(

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Blogger NoellieBellie said...

George. I couldn't even read this. I had a Videla exam this morning. Let me know when you go back to writing about girls and BCG gatherings.

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